China's Stock-Bubble Burst

China's stock bubble has burst, with its stock markets utterly collapsing
after rocketing parabolic. The failure of this popular speculative mania has
grave implications for the global stock markets. It shatters the universally-believed
myth that central banks can nullify normal market cycles. No government has
more power over its stock markets than China's, yet not even it could magically
eradicate greed and fear.

Even before their recent calamity, the Chinese stock markets had been the
most-interesting financial story of 2015. Having the world's second-largest
economy, China is immensely important in global markets. And its stock markets
were soaring, as evidenced by China's flagship benchmark stock index.
It is the Shanghai Stock Exchange Composite Index (SSEC), the local equivalent
of the US S&P 500.

By the ends of March, April, and May, the Shanghai Comp had soared 15.9%,
37.3%, and 42.6% year-to-date! Such gains were astounding, creating the equivalent
of trillions of dollars of wealth for Chinese stock investors. And unlike
major stock markets in the West, China's are dominated by its army of retail
investors. Ordinary Chinese people account for over 5/6ths of all the national
stock-market transactions.

So China's soaring stock markets truly were a popular speculative mania.
And culturally, the Chinese people are especially susceptible to the greed-drenched
groupthink necessary to fuel one. Social status among peers is exceedingly
important to the Chinese, and that is most visibly manifested in perceived
wealth. So as the stock markets powered higher, people couldn't stand the thought
of being left behind.

Their overwhelming desire for upward social mobility, and being seen as successful
by their peers, led them to aggressively buy stocks. And this went far beyond
normal investing to pathologic extremes of herd behavior. Captivated by the
intoxicating dream of fast wealth, many millions of Chinese who had never
before invested in stocks rushed to open brokerage accounts. But they were
in over their heads.

Just like in the States, these new Chinese investors had to disclose their
level of education when they opened their trading accounts. And even back in
early spring before this mania really got crazy, fully 2/3rds of all
the new investors reported only having a junior-high-level education or less!
1/4th only completed some elementary school, while 1/17th were considered "not
literate" with no formal education at all.

So literally "dumb money" fueled the popular speculative mania in Chinese
stocks. This isn't pejorative, as the lower someone's education level the greater
the odds they won't really understand what drives stock markets and how risky
they are. This amazing degree of unsophistication was evident in the way these
new Chinese investors bought stocks. Many opened margin accounts to borrow
money to do it!

Legally stock margin in China is limited to 2 to 1 just like in the US, and
the official levels of margin debt were astounding. They had hit a record equivalent
to $194b by mid-April, and kept rocketing even higher to $322b by late May.
This compared to a record $507b of NYSE margin debt in US stock markets at
the end of April. Relative to China's smaller stock markets and lower per-capita
income, this was incredible.

And the real level of using debt to finance speculative stock purchases was
much greater. Another one of China's many cultural peculiarities is the widespread
practice of ignoring all laws and regulations until caught. The legions
of Chinese investors were borrowing all the money they could get their hands
on from any source they could find to buy stocks, not limiting that to formal
margin borrowing from brokerages.

Some of this alternative financing was questionable, gray-market and even
black-market venues created specifically to circumvent margin rules. And this
extra borrowing certainly wasn't reflected in the official margin numbers.
So many Chinese investors' leverage in stocks exceeded 2 to 1. This double-edged
sword not only amplifies gains, but losses. And most Chinese investors
believed stocks couldn't fall.

This dangerous notion was actively fostered by China's government. It encouraged
the Chinese to invest in stocks for patriotic reasons, to support their nation.
Its official media outlets ran endless stories about the fortunes being won
in the stock markets. This really resonated with the Chinese need for social
status and upward mobility. And if the government was fully behind the stock
markets, what was there to lose?

Western contrarians scoff at such a silly notion, but Chinese investors grew
up totally indoctrinated to trust their immensely-powerful central-planning
government. There is no other major government in the world that comes anywhere
close to having the absolute internal power of China's, both actual and perceived,
to manipulate the markets and economy. And Beijing was pushing hard for the
Chinese to buy stocks.

It was actually China's government, via its central bank, that ignited
this stock bubble. Beijing was very worried about the weakening Chinese economy
last year. So in Late November, the People's Bank of China made a surprise
rate cut. It slashed its main interest rate by 40 basis points to 5.6%. This
was a big deal, the PBoC's first rate cut since July 2012. Chinese investors
figured a new easing cycle was starting.

And just like all over the world these days in this era of epic central-bank
money printing, that was seen as a green light to buy stocks. So capital flooded
in, and in less than 3 weeks the Shanghai Comp had blasted 23.2% higher! The
Chinese central bank provided the initial spark that ignited that popular stock
mania, and continued to nurture it whenever it faltered. Beijing really wanted
local stock prices to climb.

I suspect there were two primary motivations. First with China's economy slowing,
the wealth effect of higher stock markets would bolster consumer spending.
China is trying to transition from an export-dependent economy to one largely
supported by domestic consumption. Second, Beijing wanted to improve the international
prestige and standing for Chinese stock markets. So it convinced countless
Chinese to buy.

After the SSEC soared by nearly a quarter in a matter of weeks thanks
to the PBoC, the Chinese people really took notice. The Chinese real-estate
market was flagging along with the national economy, and gold languished down
in the dumps. So many millions opened brokerage accounts, borrowed money, and
rushed to buy stocks. Visions of fast gains clouded their judgement, the greed
for quick wealth creation.

After this rally stalled in early 2015, the PBoC sought to rekindle the euphoria
with another surprise rate cut at the end of February. And soon the Chinese
were buying aggressively again, and the Shanghai Comp skyrocketed in March
and April. As a speculator and student of the markets, I had been closely watching
the Chinese developments with great interest. By late April, the SSEC looked
like a classic bubble.

I wrote an essay warning about the extreme downside risk in the parabolic
Chinese stock markets then. That was a hardcore contrarian position to
take, very unpopular at the time. Even the vast majority of the Western analysts
believed that the Chinese stock gains would continue indefinitely.
The most common reason advanced was the ability of China's powerful central-planning
government to steer the markets.

But while governments can amplify market cycles, they can never eliminate
them. History is chock full of examples of government-inflated markets collapsing.
It's ultimately popular greed and fear that drive market cycles! No
amount of government jawboning or money printing can strike these overpowering
emotions from human hearts. And not even the most-powerful governments can
corral herd behavior.

So right at the end of April as the popular speculative mania in stocks looked
on the verge of burning itself out and rolling over, we started actively betting
against it. There are some US ETFs that track the leading Chinese stocks, led
by Deutsche's China A-Shares ETF (ASHR). I recommended that our newsletter
subscribers buy ASHR put options, because parabolic stock surges roll over
to symmetric collapses.

Indeed the Chinese stock markets dropped hard in early May, with the SSEC
plunging 9.2% in 7 trading days! With the Chinese populace so heavily invested
in the red-hot stock markets at Beijing's bidding, it was terrified of the
looming correction. So the People's Bank of China made another surprise rate
cut in early May, its third in 6 months. Convinced the PBoC would keep
easing, Chinese investors stampeded back in.

As is always the case in popular speculative manias, people were far more
worried about missing out on the next big upleg than any potential downside
risk. So the social-status-conscious and wealth-loving Chinese continued aggressively
borrowing to buy stocks. Within just 5 weeks by mid-June, they had succeeded
in forcing the Shanghai Comp another 25.6% higher! Bullishness and euphoria
were universal.

But that's exactly when prices peak. Once all investors willing to buy Chinese
stocks had deployed their capital, there were no buyers left. So in mid-June
with little fanfare and no meaningful news, the SSEC finally peaked. And once
that selling started, the unbridled greed of Chinese investors quickly turned
to naked fear. Greed and fear are asymmetrical emotions, the former
builds slowly while the latter flares suddenly.

After skyrocketing an astounding 110.8% higher in just 6.7 months thanks to
3 surprise rate cuts by the People's Bank of China, the red-hot Chinese stock
markets collapsed. The SSEC plummeted 13.3% in a single week, its worst
since the 2008 stock panic. And there still wasn't any significant news to
drive this, it was purely emotional. Herd sentiment can turn on a dime at extremes,
which is why they're so dangerous.

With its stock bubble popping, the Chinese government entered full-on panic
mode. It was terrified of the social implications of the wealth destruction
from plummeting stock markets, fearing civil unrest in particular. So
on the final weekend in June after the Shanghai Comp had cratered 18.8% in
just two weeks, the People's Bank of China tried to work its market-manipulating
magic again with another rate cut.

And that fourth surprise rate cut since November was extraordinary. Not only
did the PBoC again cut its benchmark lending rate, but it slashed banks' and
finance companies' reserve-requirement ratios. The PBoC hadn't done a dual
rate and triple-R cut since late 2008 in the dark heart of the stock panic,
which reflected the panicking in Beijing. The Chinese government was throwing
the kitchen sink at the stock markets.

But it didn't work, as heavy selling resumed in the week straddling
June and July! This shocked traders all over the world, who had come to assume
that central banks can control market cycles. All around the globe, extreme
easing by central banks has levitated stock markets to lofty levels. The belief
that central banks are omnipotent has led to unnaturally-low volatility, and
thus epic complacency, in recent years.

No major government in the world has more control over its stock markets than
China's. And if not even the all-powerful PBoC could arrest a stock-market
plunge, what hope is there for the Federal Reserve or European Central Bank
or Bank of Japan? As the Shanghai Composite kept on plunging despite that panicked
dual cut, the Chinese government got even more aggressive and desperate. It
was amazing.

In just this past week, the Chinese government tried to reignite margin buying
by allowing brokerages to accept real estate as margin-loan collateral. Chinese
investors were being encouraged to literally bet their houses on plummeting
stock markets! This was such an asinine idea that the brokerages balked, risking
Beijing's displeasure. Losing houses along with stock wealth would greatly
exacerbate civil unrest.

After that, the Chinese government convinced major brokerages to collectively
buy $19b worth of stocks. But that was a drop in the bucket compared to the
$3000b or so lost as the SSEC plummeted by 32.1% in less than a month! These
brokerages also pledged to not sell any shares as long as the Shanghai Comp
remained below 4500. And the Chinese financial industry fought the bursting
in other ways too.

Like in the US, Chinese companies can request halts in their stocks' trading
for news pending. But it's being rampantly abused in China, with companies
halting trading indefinitely to sit out this extreme selling. As of
this week, about 1400 of the 2800 listed companies on China's stock exchanges
had their trading halted! So around 50% of the Chinese stock markets were
effectively closed, yet the selling continued.

China's government continues to get more desperate, entering the realm of
the absurd. This week, major shareholders, corporate executives, and directors were
banned from selling any stocks for 6 months. All new IPOs and share offerings
have been suspended to reduce supply pressure. And the latest is the Chinese
government is promising to arrest short sellers. Beijing is panicked
beyond belief about this bubble burst!

Chinese investors are starting to realize that neither their government nor
central bank is omnipotent, that stock-market cycles can't be nullified. They
are finding out that manipulated stock markets are like a roach motel,
you can check in but you can't check out! While Chinese were encouraged to
take their lives' savings and borrow way beyond that to buy stocks, they aren't
being allowed to sell when they want to.

This is horrifying, and extremely dishonorable on the part of Chinese government
and market officials. The surest way to fan the flames of panic is to make
investors feel trapped, unable to liquidate any of their positions whenever
they want. That breeds the bearish sentiment that drives long declines after
popular speculative manias. And as China's last one in 2007 showed, today's
bust is only getting started.

After that 2007 mania peak, the Shanghai Comp plummeted 72.0% in just
over a year! And the Chinese stock markets have never fully recovered since.
I suspect they'd still be languishing near lows if the People's Bank of China
hadn't ignited and nurtured this latest bubble. And all that manipulation got
was a 7-month mania with illusionary gains that are rapidly vanishing, at the
terrible cost of devastating private wealth.

With the Chinese stock markets half frozen, we liquidated one of our
ASHR puts trades for a 151% gain for our subscribers this week. We're holding
another tranche, currently with a 207% unrealized gain, for lower Shanghai
Comp levels. While this popular speculative mania and resulting Chinese stock
bubble were blindingly
obvious to contrarian students of the markets in late April, I'm really
sad for the Chinese people.

They had faith that their all-powerful government wouldn't lead them astray,
that it could keep the stock markets climbing indefinitely. They believed their
mighty central bank could cut rates enough, and print enough money, to eliminate
stock-market cycles. Even the vast majority of Western analysts fervently
believed this. Boy were they all dead wrong! The biggest global implication
of this is psychological.

The US Federal Reserve's extreme easing of recent years has radically
levitated the US stock markets, while a similar thing happened in European
stock markets recently thanks to the European Central Bank's Fed-style debt
monetization. Once these overvalued and greatly
overextended US and European stock markets inevitably roll over decisively,
traders are going to remember what happened in China.

If the PBoC with its extreme power, control, and measures couldn't short-circuit
Chinese stock-market cycles, how on earth can the Fed and ECB hope to? Today's
lofty global stock markets are nearly totally the result of excessive confidence
in the ability of central banks and their easing to prevent material stock-market
selloffs. While history mocks that foolish notion, China's stock bubble
burst vividly proves it false again.

There's no doubt China's popular stock mania failing so catastrophically is
going to seriously erode traders' recent total faith in central banks. Yes,
their machinations can certainly amplify uplegs. But once herd mentality inevitably
shifts from greed to fear, central banks are powerless to eliminate
the normal stock-market cycles and truncate selloffs. The hard example of China
will really exacerbate coming Western selling.

With US and European stock markets artificially inflated by central banks
much like China's was, it's never been more important to cultivate great sources
of contrarian market intelligence. That's what we have long specialized in
at Zeal. We buy low when sectors are deeply out of favor, then later
sell high when sentiment inevitably shifts and investors return. This prudent
contrarian strategy has led to big gains.

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have averaged annualized realized gains of +21.3%! That's a lot of trades over
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The bottom line is China's red-hot stock bubble has burst. Chinese investors
have lost nearly a third of their wealth, much more for the margin traders,
in less than a month. And the same mighty government that fomented this popular
speculative mania has been powerless to stop its failure. Beijing is panicking
and trying ridiculous measures to halt the selling, but the fear-driven herd
is still stampeding out anyway.

As Chinese investors are bitterly realizing far too late, central banks are
ultimately impotent to eliminate normal stock-market cycles. While central-bank
manipulations through jawboning and money printing can extend uplegs and delay
selloffs, they will still always come eventually. Western investors' blind
faith in central banks' abilities to levitate stock markets indefinitely is
misplaced and dangerous, a reckoning is inevitable.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to
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